How to invest in commodities?
Commodities are products or goods like metals, food, energy, etc., that we use in our day to day lives. Commodities are a group of products instrumental in the effective functioning of daily lives. It is tradable in nature or that in simple terms things that can be bought and sold. Commodities investing or commodity trading is a lot different from trading other types of instruments.
How to start commodity trading or investing?
To start trading in commodities, you need the following things:
- Trading and Demat account with a reliable broker (Like Samco )
- Basic understanding of commodity markets
Commodity trading is generally used to hedge prices to prevent losses related to substantial price swings in essential commodities. Commodity trading is considered to be risky, so only experienced traders and investors try their hands at commodity trading.
There are five basic ways to invest in commodities:
» Invest in commodities through ETFs
» Invest in commodities through mutual funds
» Invest in commodities through options
» Invest in commodities through futures
» Invest directly in physical commodity
Let us see how we can invest in commodities through ETFs which an average risk-averse investor can use to benefit from the swings in the prices of the commodities, without owning the commodities and moreover which requires minimal research and knowledge.
Invest in commodities through ETFs
A Commodity ETF or an exchange-traded fund is a fund that invests & focuses on a particular physical commodity or commodity futures contracts. These funds(ETFs) are in turn traded on the exchanges. ETFs provide indirect exposure to the prices of the commodities and avoids the risks associated with holding a futures contract.
Commodity exchange-traded funds track the performance of multiple commodities or several companies engaged in the mining, extraction, or cultivation of a particular commodity. Commodity ETFs allow investors to potentially benefit from the fluctuations in the prices of the commodities without investing directly in the commodities through futures contracts.
Advantages of commodity ETFs
There are a lot of advantages associated with the trading of commodity ETFs.
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Affordable
Commodity ETFs are inexpensive as they have lower expense ratios than mutual funds. Most ETFs that merely track indices are passively managed hence doing away with operating fees or costs associated with active funds managed by a fund manager.
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Liquidity
Commodity ETFs can be freely bought or sold in the stock market, hence providing greater liquidity.
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More transparency
Since they are actively bought and sold on the stock market, there is greater transparency preventing any risk of manipulation.
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Diversification
ETFs provide diversification as it is not concentrated on one particular commodity or one company producing a specific commodity. This is hugely beneficial, especially when it comes to commodities as the prices of the commodities are extremely volatile and highly unpredictable. Hence losses suffered in one commodity are offset by the gains attained in other commodities. Similarly, losses experienced by a subset of companies are mitigated by gains achieved by other companies associated with the same commodity.
Since gold has been considered as a safe haven in trying times since aeons. Exchange-traded funds typically holding gold as the underlying commodity are quite popular in India.
Some examples of gold ETFs:
| Commodity ETFs | 1 Year Returns | 3 Year Return |
|---|---|---|
| HDFC Gold Exchange Traded Fund | 8.99% | 6.13% |
| UTI Gold Exchange Traded Fund | 9.02% | 6.21% |
| Nippon India ETF Gold BeES | 8.87% | 6.16% |
These ETFs are considered to be less risky than traditional ETFs; hence, the returns may be limited. Exchange-Traded funds usually are passively managed.
Invest in commodities through mutual funds
Mutual funds, just like ETFs, provide indirect exposure to the commodities market without indulging in the trading of highly leveraged (risky financial instruments) such as commodity futures and options.
Advantages of investing in commodity mutual funds
Expert fund managers:
In addition to ETFs, mutual funds are managed by an astute fund manager which opens up the possibility of higher returns than the general rate of return attained by passively managed funds
Diversification:
Mutual funds typically invest both in the stocks of the companies engaged in the business of these commodities as well as in actual commodities. This adds an extra layer of diversification. As mutual funds may perform well even when the overall commodity prices are falling.
Hedging against event risk
The prices of commodities are influenced by events unrelated to commodities affecting the supply and demand of commodities such as war, riots, etc. In the absence of any unrelated event, it is affected by the interplay of supply and demand with absolutely no dependence on the fundamentals of the company associated with the commodity.
Stocks and commodities tend to have a low or negative correlation with each other. Hence, the prices of petroleum companies may rise even if the spot price of crude oil may fall.Even if there is a downturn in the economy, the commodity prices have shown a tendency to rise. E.g., during the Great Recession period, from the late 2000s into the early 2010s, gold prices proliferated from 800$ and ounce to 2000$ an ounce (for better understanding at current dollar/rupee exchange rates would be Rs 58,780 an ounce in 2008 to Rs 1,46,954 an ounce in 2010).
Hence, more and more investors are flocking to commodity based-mutual funds that provide a reasonable rate of return while riding the alternate and frequent periods of booms and busts.
Invest in commodities through options
Another investment option for commodities is commodity options.
As per 2017 SEBI regulation, traders can trade in top commodities through options trading which offers the traders the right but not an obligation to buy/sell the underlying commodity at a predetermined price on the expiry date in the future. The set price at which the trader can buy or sell the commodity in the future is known as the strike price.
Unlike futures, where the trader is obliged to serve the terms of the contract involving buying and selling the underlying commodity at a specified date in the future, the option contract provides the right to the trader to forgo the deal if it doesn't serve the interests of the trader or exercise the right to buy or sell the commodity if he is profiteering from it. They attain this right by placing a nominal amount known as option premium.
There are two types of options:
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Call options: Gives the trader the right but no obligation to buy the underlying commodity at an agreed price at a specified date in the future. Example: I buy a call option meaning i agree to buy a commodity at Rs.100 on 20th Oct 2020.
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Put options: Put options gives the buyer the right but not an obligation to sell the underlying commodity at an agreed price at a specified date in the future.
In layman terms, You buy a call option if you think the prices of a commodity are going to rise and you buy a put option if you estimate that prices of a commodity are going to fall.
A call option buyer will make money when his strike price or agreed price was Rs.100 at the time of buying and the current market price is Rs.120 and vice versa for put options.
MCX country's largest commodity exchange offers options in gold, silver, crude oil, copper and zinc
NCDEX offers options contracts on chana, guargum, guarseed, soya bean, and soya refined oil.
Invest in commodities using futures
The most common way to invest in commodities is through commodity futures.
What are commodity futures?
A commodity futures contract is an agreement to buy or sell the underlying commodity at a fixed price on or before a specific date in the future. Commodity futures are offered for a variety of commodities in India such as wheat, cotton, petroleum, gold, silver, natural gas and so on.
About commodity futures
Commodity futures are generally used by producers of commodities to hedge against the risk of fluctuation in the prices of commodities during the time of production, before the commodity is ready to be delivered. E.g., a farmer may buy wheat futures to lock-in a price a month ago, an adequate amount of time that as per his estimation and experience may take the wheat to grow fully. At the time of the harvest, not only is he assured of a reasonable price but also guaranteed a buyer at the time of the harvest.
The assurance of a buyer for the delivery of the agricultural produce such as wheat at the time of the harvest is particularly crucial as it avoids wastage of the produce due to the time lapsed in finding a buyer in the absence of the futures contract, as agricultural commodities are highly perishable in nature.
Also, the futures contract iron out any changes in the prices of wheat during the harvest time, which may result in substantial losses to the farmer, and guarantees a price that provides him with a reasonable rate of return.
The buyer of the wheat may be a manufacturer of wheat flour; he is guaranteed a price at which he can source the wheat. This enables him to plan the production schedule accordingly, as he is assured of the supply at the appropriate time, and he doesn't need to go scouring for wheat producers, when he needs the most.
Also, as he is assured of a price, he can accordingly determine the price of the wheat flour and take management decisions to keep the price under a certain limit that ensures him a reasonable margin.
Any disruption in the supply or swings in the price of wheat can jeopardise the whole production schedule or even hike the price of the wheat flour, thus making the product unviable for the customers. So a futures contract is not a zero-sum game but a win-win situation for the buyer as well as the seller.
Also, there are speculators in the futures market that are attracted to futures because of the high leverage it provides as any insignificant price increase can lead to substantial gains. On the other hand, a small dip in the price can lead to significant losses. However, the speculators also serve a purpose in the market as they enhance liquidity in the market, ensuring there are sufficient buyers and sellers.
For a detailed understanding of the mesmerising world of the futures market, please look up the article Commodity Futures Trading.
Invest directly in physical commodity
You can invest directly in a physical commodity by purchasing specific quantities at a set price and reselling it later at a higher price, thus fulfilling the apparent objective of earning a profit.
Challenges of investing directly in physical commodities
There are innumerable challenges involved in trading physical commodities
You need to figure out the logistics to take the delivery of the commodities normally in humongous quantities
You need a large and extensive space to store such a massive amount of commodities, which is often cumbersome and practically difficult unless you're a farmer.
You also require specially devised storage facilities to protect the commodities from adverse climatic conditions, erratic weather or weather shocks, to prevent any spoilage or wastage.
You need a comprehensive insurance plan to protect against the risk of total or partial loss of commodities due to unforeseeable circumstances, such as weather, natural disasters, man-made disasters wreaking havoc on the commodities, while it is stored
A trader often finds it impossible to find a buyer willing to pay the market price for the exact quantity held by the trader, in contrast to an exchange which functions as a centralised location for buyers and sellers to transact facilitated by the constant and immediate matching of buyers and sellers.
Hence, these challenges make investing in physical commodities a too costly affair, and time prohibitive.
E.g., consider you bought 300 kgs of silver, and you live in a cramped, densely populated city like Mumbai with no godowns and warehouses of your own. It's virtually impossible for you to store such an immense quantity for a city-folk like you who merely want to profit from the price fluctuation in silver, and have no interest in possessing the physical commodity.
Moreover, in case you wish to sell, you must find a buyer with the requirement of the exact quantity of silver, i.e. 300 kgs and willing to pay the market price, pretty cumbersome to do so in this widely entrenched market with absolutely no presence in the market. Also, you must acknowledge the massive costs incurred while maintaining and preserving the quality of the silver in storage.
On the other hand, you can merely buy 10 futures contracts of silver at 30 kgs per contract at the MCX. No physical commodity involved, no logistics, no warehousing requirements and you can freely buy or sell the contracts as per your wish. Moreover, you can take a position in the contract by placing a fraction of the amount as margin as compared to buying physical commodities where you need to shell out the total amount.
Hence considering these massive drawbacks and restraints, the commodities markets have designed financial instruments such as ETFs, futures, and options as mentioned above to gain exposure to the prices of the commodities without actually owning them and profit from the swings in the prices of such commodities.
Watch this video to learn commodity trading - must watch for commodity trading beginners.
To start trading and investing in commodity market, take the first step and open a free commodity trading account with Samco today and get 100% brokerage cashback for the 1st month on all orders placed from the StockNote app.
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